One of the signature regulatory innovations to emerge since the financial crisis began in August 2007 is the annual stress test. Conventional wisdom, as sold by the bank regulators and the bankers, is these tests were critical to restoring market confidence in the banks as they provided transparency into each bank’s solvency.
In fact, the tests do provide transparency into each bank’s solvency. They just don’t do it the manner described by regulators.
The regulators said the tests restore market confidence because they are accompanied by the release of information by the banks. However, this faux transparency is inadequate for any market participant to actually independently run the stress tests for themselves to confirm the results. This faux transparency is also inadequate for any market participant to run stress tests using their own assumption.
So how do the tests provide greater transparency into each bank’s solvency and restore market confidence?
When the first stress tests were done, as revealed by the Federal Reserve, the Treasury guaranteed it would inject all the capital needed by the banks so they remained solvent. I refer to this as the Geithner Guarantee.
The market understood the Geithner Guarantee. From the market’s perspective, it equates each bank’s successfully passing a stress test with the government standing behind each bank and guaranteeing the investors in unsecured debt and bank equity will not lose money from any solvency issues. As a result, bankers were now free to gamble as they are not subject to any market discipline and know they will be bailed out by the taxpayers if they lose money.
This is the very definition of moral hazard.